Uneven Development and the Dynamics of Distortion

This paper develops a two-country, two-sector model of international trade with increasing returns to scale in one sector. Free trade leads to asymmetric equilibria even when both countries are identical with respect to technology, tastes and factor endowments. For some parameter values, trade leads to a uniform welfare improvement in both countries, while for others it can give rise to uneven development in the sense of persistent disparities in wages, income and welfare. In the latter case, distortionary industrial policy by the less developed country may be welfare enhancing. If the dynamics of policy changes are endogenized, the model gives rise to periodic changes in industrial leadership or leapfrogging. Implications of this phenomenon for the empirical literature on convergence are discussed